A MOTLEY FOOL CANADA SPECIAL REPORT

WHY SMALL-CAPS

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Last, summer Bryan Hinmon, the Chief Investing Officer at our sister company in the U.S., Motley Fool Asset Management, LLC, had a chance meeting with an MBA student interning for the summer with Akre Capital Management. Possibly you aren’t familiar with the name Chuck Akre, but he’s a lion of value investing with a long-term track record that rivals the best in the mutual-fund business.Chuck Akre is a friend of the Fool, too. He’s been generous with his time and insights whenever we’ve called on him. He’s also, as a fund manager who runs a very concentrated portfolio, highly convicted in his ideas.(By the way, yes, we said “value investing.” Akre Capital also practices focused investing, holding relatively few positions. Their flagship fund owned just 26 positions as we write this, with the largest position amounting to nearly 14% of assets. Its investments are primarily in large- and mid-cap stocks like Visa, MasterCard, CarMax, and Moody’s. Well-known, massive companies. They also hold their positions, on average, in excess of six years.)So Bryan, being a Foolish student of investing, was curious what work he might assign an intern there for only a few weeks. You’d have to figure an intern in such a position would be tasked with analyses of companies already in the portfolio that involve calculus, a slide rule, Greek alpha numerics, the largest spreadsheet you’ve ever seen, and a healthy dose of minutia. But no, Chuck Akre’s ask was much more surprising. On the first day that he sat with the intern, he made sure he knew what resources were available to him, and then gave him this task:“You have seven weeks to find a 100-bagger and present it to us.”Where do you find one-hundred baggers?So why would a man armed with an elephant gun like Chuck Akre send an intern on a unicorn hunt? Doesn’t that seem like a waste of time? To us, the logic is sound — he did it to force the intern to place absolute focus on the size and duration of a company’s competitive advantage.

Why Small-CapsSo let’s stipulate something here. The stock market does not tend to simply leave in plain view opportunities for an investor to increase their money by a hundredfold. That return transforms $25,000 into $2.5 million. To find such an opportunity, we think you should take these three actions:

1. Search in places where they might lurk;2. Think in a way that is different from the majority

of other investors searching in that area.3. Be very, very, very patient.

So let’s consider those actions one by one.

1. Look in the right placeIf you’re looking for a hundred-bagger, you have to tune your attention to small-cap stocks. We here at The Motley Fool Canada have shown great admiration for (and, along the way, have profited handsomely from) companies like Brookfield Asset Management, CN Rail, Agrium, and Alimentation Couche-Tard. But simple math will tell you that these companies, with market caps ranging from $17 billion to $92 billion today, can’t possibly be 100-baggers from here. Likely not even 50-baggers. Expecting companies to earn hundreds of dollars of economic value for every man, woman, and child walking the planet is simply unrealistic.Again, to find a 100-bagger, you probably have to focus on small-cap stocks. Let’s restate this a little: In order for you to invest in that one company that will completely transform your financial situation, you have to be searching among ones that have ample room to grow. Of course, you don’t need a 100X return to transform your personal wealth. But, even for 50-baggers, the vast majority of these big winners are smaller, less-well-known companies today.We have some good news: There are more than 3,000 companies on the TSX and TSX Venture with market caps below $5 billion, with more than 950 ranging between $50 million and $1.5 billion.Look here. We are, too.

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2. Think differentlyWe’re actually going to dispense with two interlocking points upfront. First, let’s talk about thinking differently from people who are investing in individual small-cap stocks, and then we can talk about thinking differently from those who are not.Our Foolish colleague in the U.S., Tim Hanson, recently sent a screenshot around from a writer who divided the investing community into three distinct groups:

1. High-speed traders with the technology and speed to react fastest to news;

2. Low-speed traders who realize they lack this technology and therefore do not attempt to trade on news; and

3. Idiots.We love this construction… because it’s funny. We also love it because it reinforces something that we have said since the first day The Motley Fool opened its doors: Long-term, business-focused investing in great companies at compelling prices is the way to generate wealth for the individual investor.Let’s recast this in a way that is perhaps less humorous but certainly more helpful. There are essentially three main places where an investor can gain an edge: information, analysis, and time horizon.It has rapidly become impossible for the average Fool to gain an information advantage. The stock market is as competitive an environment in which any of us competes. In recent years, as both hedge funds and passive investing vehicles have proliferated, the chase for attractive returns has become more furious. When high-profile investors like Warren Buffett and Seth Klarman opine that the markets are much harder than they used to be, we aren’t surprised.We think that’s because the information edge that they used early on to make their fortunes has largely been worn away by the speed at which information gets distributed today. The information edge essentially now exists only for high-speed strategies, as well as, for people willing to illegally trade on inside information (or are they kind of the same thing, ahem).But the lack of an informational edge leaves two other potential places where outsized investment returns can come from: analysis and time horizon. Or more pertinently, both in combination.Our analytical advantage emerges because so few large investors can participate in lower-volume, small-cap equity investing. We build on that edge through

a willingness to think deeply about companies, and, potentially, to study them for years before investing in them. And then being willing to add to our winners as the years pass. And all of this takes time and a proper temperament, something many investors lack.

3. Be very, very, very patientWho of us has never dreamed of making millions in an instant? A lottery ticket. A few coins in the slots. A mint condition, 1979 Wayne Gretzky O-Pee-Chee rookie card just lying on the street corner in front of us. Sure, a Fool can dream.But how much more effective to dream rationally. Millions of dollars are sitting out there available for us in the public markets, if only we know how to get them. And the simplest way to get them is to let time do the work for us.The list of wealthy daytraders throughout history is terrifyingly short. And then you have a kid in Omaha who put his savings into the market, almost never sold along the way, and has now amassed a fortune of $76 billion. Investing isn’t quite a zero-sum game, but Mr. Buffett has certainly taken his share of dollars away from impatient and overly emotional traders.Here in Hidden Gems Canada, our idea of patience begins with a minimum holding period of five years and an optimal holding period of forever. Sure, we’ll all eat some losers for this. But the compounding machines and big home run knocks that we accumulate can be expected to more than make up for the losses. And we’ll twiddle our thumbs, watching our businesses make us wealthy, while deferring capital gains taxes way out in the distance. Join us.The rapid rise in the past few years of passive investing and exchange-traded funds has, oddly enough, created the potential for additional opportunities for people willing to think differently about investing in small-cap stocks. By the end of 2016 more than $3.2 trillion in investible assets was held in passive exchange-traded funds. We can debate the good versus bad of passive investing (we generally view passive investing as a positive), but here’s something else about passive investing that is true: As it becomes a larger and larger component of trading volume, it means that there are (through the magic of subtraction) fewer market participants attempting to value individual securities. This, in some ways, makes the market much more brittle, which concerns us. But fewer eyes also means that there is a higher chance of market inefficiencies.

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Have you ever wondered why the largest hedge funds in the world all seem to hold stakes in Apple, Facebook, ExxonMobil, and the like? It’s because they have to. Have you wondered why, statistically speaking, the S&P/TSX Composite index is at its most expensive valuation on a cyclically adjusted P/E basis in nearly a decade? Perhaps… perhaps! It is at least partially due to the buying pressure that’s come along with billions of dollars of inflows into passive investing strategies.This is why we want to fish elsewhere, using patience to buy companies that we consider prime candidates for long-term capital appreciation. And it’s also why we think we can bring the hammer down on the biggest potential advantage we have as investors: a long time horizon.This is why we think that when extremely smart investors like Warren Buffett rue the fact that information advantages no longer exist, they completely give short shrift to the edge that has grown by having a long-term horizon. In a world where the biggest players in the game measure their returns in weeks and months, and billions of dollars have given up trying to look, the advantage available to people who are willing to buy stocks and hold them for years has gone up. If you can let go of the short term and focus your time and energy on companies you believe will be much, much more valuable in five years, you have reclaimed the biggest, best advantage that exists in the stock market today.And while there are several places we might suggest the enterprising investor look to find such home runs, the most accessible one to us as individual investors is in the small caps listed right here in North America, and more specifically, on our two major Canadian exchanges.The stocks that made our home run universe.If you’re trying to rip a slapshot, it’s a heck of a lot easier to make a puck travel 160 km/h than it is to make a basketball travel that fast.Mega-caps like, say, Enbridge or the banks are all basketballs, with market caps well above $40 billion.Our pucks are orders of magnitude smaller. We’re looking for companies as small as $50 million and no larger than $1.5 billion. In other words, companies that are a tiny fraction of the size of the largest companies in the TSX, which are the ones that everyone owns.These puck-sized companies lie within an investing

sweet spot: They’re large enough that they’re out of dangerous penny stock territory but small enough that we may be able to ride them for many years as they grow much, much larger.The reason you’re here is that you already realize investors who ignore this sweet spot are missing out on piles of potential opportunities in the stock market. And by “piles” we’re talking close to 1,000 companies that fit with our $50 million to $1.5 billion range noted above. That’s in the Canadian market alone!You don’t think there’s a life altering return or two hidden within that pile of 1,000 companies? We sure do. The potential reward for looking under rocks others step over is simply breathtaking. Let’s look at some research on the tiny end of the market.Turning to the data rich U.S., Ibbotson Associates conducted a study spanning 1926 to 2010. Over that period, small-cap stocks returned 12.1% per year on average, easily besting the 9.9% return of large-cap stocks. And while that may not sound like much, consider that $1 invested in small-cap stocks would have turned into $16,055, vs. $2,982 for large caps. The power of compounding!Small-cap stocks have also outperformed over shorter periods of time, and even during periods of abnormal distress. During the 10-year period from 2001 to 2010, a “Lost Decade” that included the tech burst and global financial crisis, small caps actually turned $1.00 into $2.51. Large caps turned $1.00 into just $1.15, failing to keep pace with inflation over the same period.Allow us to make an assertion that probably can’t be borne out by data. We think that if anything, the Ibbotson statistics understate the advantage that small-cap stocks have over large caps, on account of the fact that a substantial percentage of the companies that are currently listed as small caps are former – and failing – large caps.Consider, before it filed for bankruptcy, Nortel was a small cap (poor, poor Nortel – will we ever leave it to rest?). Another BCE spin-out, Yellow Pages was a former market darling until something called Google came along and upended the apple cart. After a spat with insolvency, this still struggling company is living out its life with a market capitalization of about $130 million. And how about Sears Canada? At the turn of the century, this company was worth about $3.9 billion. Today….$124 million, and falling fast.

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The price of performanceWhen you’re swinging for the fences, there are at least two additional risks above the risk every stock market investor assumes.The first is added volatility. Smaller stocks tend to fluctuate more than larger stocks. In a given year, small caps can be quite risky. But the longer you hold, historically speaking, the lower your risk. See the chart below that plots the range of outcomes using the Ibbotson Associates data we talked about earlier. Notice the wild swings of one-year holding periods versus the uniformly positive returns of 20-year periods.

Reduction of Risk Over Time

The second added risk of going small is “winner concentration.” We did our own historical study of 1,492 Motley Fool stock recommendations in the U.S. and found that roughly 10% of the stocks (140) drove 80% of the returns! So in a portfolio of 30 smaller-cap picks, it’s reasonable to assume 80% of returns over time could be driven by just three stocks. Many of the others are very likely to cause some degree of heartburn.Putting those risks together, buying to hold and broad diversification are imperative if small caps make up a meaningful portion of your portfolio.In addition, it’s wise to limit your exposure to small- and mid-cap stocks to just 20% to 30% of your overall portfolio, depending on your stage in life. As a rough guide, here are the three model portfolio allocations we provide in our Rule Your Retirement service in the U.S. :

The truth is that the path isn’t always pretty. Over long periods of time, many small caps will go bankrupt, some will be acquired before they hit their stride, and others will meander, but a few will go on to compound their investors’ capital at a pace so high that they can lift the return of an entire portfolio. More on that in a minute.

The opportunityWhen we reviewed our recommendations in our U.S. services* over the years, we found both our larger-cap (over $10 billion) and our smaller-cap (under $10 billion) selections beat the market. But, much like others have seen with the market as a whole, we noticed that our smaller-cap picks performed better than our larger-cap picks:

The Motley Fool’s U.S. Service Outperformance of the S&P 500

*Includes Stock Advisor, Rule Breakers, Hidden Gems, Income Investor, and Inside Value.

Given all of this, our goal with this Hidden Gems Canada portfolio is 15% annual returns over a long-term (5+ years) time frame. Keeping in mind what we said about volatility before, please note that this doesn’t mean that we will see 15% each and every year. We expect this collection will provide annual performance that’s either above or below, and potentially well above or below that 15% level on an annual basis.To accomplish this goal, we’ve mostly ignored the highest-profile stocks in the Canadian, and US, markets because they’re just too big to be that one-in-100 stock that drives a fortune. We’ve certainly picked some stocks you’ve heard of, but they are

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great businesses early enough in their growth cycle to have decades of outsized growth ahead of them. So no matter if it was an obscure company in a boring industry or a well-known company in a sexy industry, the company’s stock had to at least have a chance of being a big winner Companies that we’ve followed for years as well as those drawn from fresh research and analysis were tossed into the ring. From there, we debated, battled, argued, and hugged until we finally agreed on the collection of companies for this report.Now, admittedly, the number of companies included may seem a touch overwhelming. However, we believe it’s a manageable number that you can add to the small- and mid-cap portions of your portfolio to get the proper diversification we talked about earlier. Our hope and wish is that each of you buys all of the companies described and holds each for at least five years — but preferably for a decade or longer. Put ‘em away!Remember that 1) according to our research, 80% of the returns could come from just three of these stocks and 2) small-cap returns are all over the place in the short-run but tend to outperform in the long-run.As you go along on your investing journey, remember the story of Ronald Read. He was the janitor/gas station attendant who posthumously made the pages of the Wall Street Journal. After his passing, the world was shocked to discover enough stock certificates to estimate his net worth at almost $8 million! He was a true Fool. He held “at least 95 stocks at the time of his death, many of which he had held for years, if not decades. They were spread across a variety of sectors…”Diversification? Check. Long-term buy and hold? Check. Hockey pucks to basketballs? Check.And as we inevitably buy our share of losers, take heart…

“Mr. Read didn’t always hit home runs. His portfolio included shares of Lehman Brothers Holdings, the financial firm that collapsed in 2008, for example. But he was willing to stick with his picks for many, many years.”Want to see a bigger disaster than holding Lehman Brothers? This came from an old friend of one of us just a short while ago. This is a smart guy, and a really sharp investor. Unfortunately, he had the ticket to transformational wealth in the palm of his hand and walked away from it!

Don’t do this, please. The Fool believes strongly, as Warren Buffett does, that our company’s investing performance has been actively harmed by our ever selling a stock. The number of losers that we sold that went on to deliver market-beating returns makes us question, with great prejudice, the wisdom of ever selling a share of stock.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Fool contributor Tim Hanson owns shares of Alphabet (C shares), Apple, Mastercard, and Visa. David Gardner owns shares of Alphabet (C shares), Apple, Canadian National Railway, and Facebook. Tom Gardner owns shares of Alphabet (C shares), Facebook, and Mastercard. The Motley Fool owns shares of Alphabet (C shares), Apple, Canadian National Railway, CarMax, Enbridge, Facebook, Mastercard, Moody’s, and Visa and has the following options: long January 2020 $150 calls on Apple and short January 2020 $155 calls on Apple.

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